While the outcome of a Conservative majority means much of the market can get back to business as usual, Jane, manager of Miton’s multi-asset funds, warned that for those holding sovereign bonds there are other, more ominous factors at play.
Jane conceded that while the UK bond market sell-off earlier this week came as a surprise, he believes suggestions that it is election related are misguided, saying that not only can the source be traced to the bunds trade, but there is likely more to come.
He said: “A lot of people of people were short-duration going into the election, and the UK market heading up is a knee-jerk reaction – it will disappear into the chart on a 10-day view.
“The move in German government bond yields is far more important in the short to medium-term.”
“The sell-off we have seen in UK 10-year market in the past week has been extraordinary. However, rather than the election, it had far more to do with the German bond market, which went from seven basis points to 59 [on 6 May].”
Rather than the European Central Bank’s quantitative easing policy causing the bund yield curve to be compressed, as was widely expected, Jane says that the reverse has happened, highlighting the damage this will have done to investor capital.
“Since the beginning of the year, the presumption has been that ECB QE will drive bund yields lower and the curve will continue to flatten towards having negative yields at the short end,” he explained.
“For a short-end buyer of 10-year bunds, a fifty basis point move is a 5% capital loss – if you have that trade on and you have levered it then that is going to hurt a lot.
“The bond bull market has been driven by capital momentum and directional trade as opposed to anything that can justified by valuation. If you a German bund investor and you bought at 0.08% yield, if you lost 5% of your capital over the course of five days then the difference between risk and reward is profound, which has been brought home to a lot of people this week.”
And not only is this detrimental for those with cash deployed within the space, says Jane, because of the intertwined nature of the modern market, rising bund yields could have far-reaching implications throughout the global sovereign bond universe.
“If bund rates keep going higher it will be a fundamental and profound change for investment environment,” he explained.
“If people decide that they want to reverse the trade more broadly, then the potential for a slow long-term grind higher in yields and negative total returns does not look attractive. It could have long-term effects in other bond markets.
“The reversal of that flattening trade is very important for hedge fund investors, who tend to gear themselves up too much. If German 10-year rates continue to grind higher there will be implications for deficit-running European countries and even the UK bond market, which has traded off the German and US curves for a while.”
So with a relatively bleak outlook on the sovereign bonds front, where should fixed income investors take their hunt for yield?
“If you at the very short end, in Europe you are getting negative yields and the UK you are getting zero,” said Jane. “You can own credit, where there are spreads above the very low short-term interest rates. But spreads are at historic narrows, so total returns are not looking exceptionally high.
“High-yield is not high anymore, but it looks to be the best option in what is not an attractive range of opportunities. If you go short-dated then you are buying credit risk on the basis that economies will right and you will not get credit losses.
“A lot of people are further down the yield curve and will have experienced losses in the last week – the best place to be is at the very short end, where you will not get as much capital volatility while seeing some income pick-up. But no one is going to make a lot of money – in our portfolio we are targeting returns of 3% and will be very pleased if we get them.”
Having previously been long Japanese and European equities in his portfolio – which includes the PFS Darwin Multi Asset, CF Miton Total Return, CF Miton Cautious Multi Asset and CF Miton Defensive Multi Asset funds – Jane trimmed his equity exposure in early April.
“We trimmed our equity exposure about a month ago, from the high 50s to mid-40s,” he said. “It is sitting in cash at the moment and we will let the market settle again before redeploying. We were very long Japan and Europe.”
On the bonds front he is also guarded, in line with his preference for short positions.
“We have been taking a cautious stance in general,” he said. “We are very short-duration in bonds.
“At the end of January we had a duration of 13 years on the cautious fund, which is now at three years.
“We have also trimmed the REITs because of the bonds going higher, taking them from 13% to 8% of the portfolio.”
